Wednesday, October 2, 2013

What George Bailey Can Teach Us About QE

Quantitative easing (QE) is a lot like George Bailey in the classic film It's a Wonderful Life. George was a man who began questioning his value to society. A number of cascading events--unfulfilled life dreams, a run on his bank, lost bank deposits, bank fraud charges--made it appear to hm that he was on balance a drag on his community. George decided it would be better for all if he 'tapered' or ended his life. Fortunately, an angel appeared at the last minute and revealed that despite his immediate problems, George's overall contributions to society were immense. Many lives were saved and changed because of his efforts. All that was needed to see this fact was a broader, longer perspective. George Bailey, in other words, was not doing the right counterfactual.

The same is true for skeptics of QE. Many point to the apparent flaws of the Fed's large scale asset purchases (LSAPs), but fail to step back and consider the counterfactual of what would have happened in their absence. This point is particularly poignant to those observers who claim the Fed's LSAPs of treasuries are particularly bad because they drain the financial system of safe assets. These critics note that these safe assets serve as collateral in the shadow banking system and thus facilitate transactions. Therefore, when the Fed increases its balance sheet it is actually restricting the funding capabilities of the shadow banking system and creating a drag on the economy. A growing number of smart people are making this point, including Izabella Kaminski, Tyler Cowen, Peter Stella, Arvind Krishnamurthy and Annette Vissing-Jorgensen, and Michael Woodford. I contend that while correct on the immediate effect of LSAPs, these critics like George Bailey are doing the wrong counterfactual. The right counterfactual is what would have happened had there been no QE2 and QE3 at all.

Before delving deeper into this counterfactual, I want to mention two other points about this critique. First, most of the safe asset shortage was created by factors other than the Fed's LSAPs. On the supply side, there was the destruction and subsequent anemic recovery of private-label safe assets as seen in this figure. On the demand side, the financial crisis and then a spate of subsequent bad economic news--Eurozone crisis, China slowdown concerns, debt
limit talks, fiscal cliff talks--has kept the demand for safe asset
elevated. Also, new regulatory requirements requiring banks to
hold more safe assets is keeping safe asset demand elevated.

Consequently, forces other than QE2 and QE3 have been driving much of the safe asset shortage. This can be seen in the figure below which shows the treasury general collateral repo rate and the Fed's share of marketable treasury securities. Note that the largest drop in the repo rate (reflecting the reduced supply and increased demand for treasuries collateral) occurred between late 2007 and early 2009, the very time the Fed was releasing treasury securities back into the market.

Second, even though the LSAPs do cause an immediate drain of safe assets, they potentially lead to more private safe asset creation. As I noted before:

The LSAPs, if done right, should raise expected economic growth going
forward and cause asset prices to soar. This, in turn, would increase
the current demand for and supply of financial intermediation. For
example, AAA-rated corporations may issue more bonds to build up
productive capacity in expectation of higher future sales growth.
Financial firms, likewise, may start providing more loans as the
improved economic outlook makes households and firms appear as better
credit risks.

There is some evidence this is happening with QE2 and QE3. Even if these private safe assets are not used as collateral in the repo markets they will be used elsewhere to satiate liquidity demand. That, in turn, should free up more treasuries for use in the repo market. Both of these points are often overlooked by QE critics.

Now back to the counterfactual point. Are QE critics really making the same mistake as George Bailey? To answer that question, let's think through the counterfactual of no QE2 and QE3. First, assume the Fed's share of marketable treasuries was constant over this period. Also, assume that the shocks from the Eurozone crisis, China slowdown, debt
limit and fiscal cliff talks still buffeted the U.S. economy during this time. What would have happened to the U.S. economy? Could the U.S. economy have been as resilient to these shocks had the Fed not been supporting it? If not, then imagine the mess in the financial system and what that would have done to the demand for safe assets. Repo markets, for example, would probably be facing an even larger collateral shortage. A reasonable counterfactual, then, is that the safe asset problem would be greater were it not for the Fed's QE programs.

I took this idea to the data. I estimated a vector autoregression (VAR) over the 2003:1 to 2013:8 period and used it to create a counterfactual path for the 2010:10 to 2013:8 period.1 This corresponds to the QE2 and Q3 periods. VARs are great for this type of exercise because one, they allow the variables in the model to interact and two, you can do dynamic forecast with them. The only twist here is that I did a conditional dynamic forecast. Specifically, I dynamically forecasted what would happen to employment, the stock market, PCE core inflation, and the repo rate conditional on (1) the Fed not increasing its share of marketable treasuries and (2) allowing the Eurozone crisis, China slowdown, and fiscal policy shocks to still affect the economy. For the latter, I used the actual, realized values of the economic policy uncertainty index over the forecasted period as a way to summarize and include these shocks in the VAR. The results can be seen in the figures below.

The first figure shows counterfactual path for the Fed's share of marketable treasuries used in the forecast.

The next figure shows what happens to the stock market. It declines over much of the period.

The following figure reports the counterfactual path for employment. Again, not a pretty picture.

This next figure shows that core PCE inflation stays around 1% and never recovers. So QE is inflationary, at least relative to where inflation would be in its absence.

Finally, this figure shows that the repo rates would have gone negative. Now this would not happen in practice because of the ZLB. But the VAR does not know the ZLB and simply forecasts based on estimated relationships. The fact, though, that it goes significantly negative is instructive. It indicates the repo markets would have faced even greater collateral shortages had the Fed not done QE2 and QE3.

Now we do not want to read too much into these results. They come from a forecasting model that is far from perfect. Still, they indicate that a proper counterfactual of the QE programs requires more than just narrowly looking at the immediate impact of LSAPs on the collateral asset supply. We do not want to be like George Bailey and do the wrong counterfactual. Neither should the Fed. Otherwise, it too may be tempted to pull the trigger and taper too soon.

My assessment is that QE2 and QE3 has done more to shore up the U.S. economy than many observers realize. We do not know how much worse the economy would be in their absence, but the analysis above suggests it could have been ugly. With that said, the QE programs have been flawed because of their ad-hoc, make-it-up-as-we-go-along approach that
until recently was not tied to any explicit target. Tying the LSAP more firmly to conditional outcomes would do much to improve them. The more rule-like and predictable the better. I think George Bailey would agree.

1The VAR was estimated with the Fed share of market treasuries, the log of SP500, the log of employment, the core PCE inflation rate, the repo rate, and the economic policy uncertainty index. Six lags were used on the monthly data. The results were generally robust to longer lag lengths, but due to limited data six lags were chosen. The conditional forecast was created by imposing fixed values for the Fed share and the uncertainty index as noted above.

9 comments:

"....it is actually restricting the funding capabilities of the shadow banking system and creating a drag on the economy."

Do you mean that the restriction of funding opportunities of the shadow banking system is actually the cause of the drag on the economy?

It is fairly easy to see that a reduction in the supply of safe assets is going to be associated with a reduction in transactions which fund those self same assets. But those funding transactions are obviously only undertaken by people who are either long those assets anyway or are taking them in as collateral on some other position. It doesn't help someone who wants to borrow to spend on produced assets.

What is the transmission mechanism by which a decline in shadow bank repo, as a result of safe asset shortage, impacts on the real economy?

For are start, I'm not sure that it's correct to see borrowers as constrained by a safe asset shortage. It's not like the safe assets have just magically disappeared - they've been sold for cash. The reason funding has gone down is nobody uses cash as collateral for borrowing cash - they just don't borrow. Repo funds asset holdings - if you don't hold the assets , you don't need the funding. If there is a constraint from a safe asset shortage, it's on lenders who face fewer opportunities for secured lending.

Banks can't fund customer loans with repo, because they need to use the funds to get the collateral in. If more safe assets were now provided to the market, banks would have to somehow get hold of the collateral in order to do more repo, in which case they would have to use the very funds they could have used to make the customer loans in the first place.

I've looked through quite a bit of stuff written on this and although there's plenty explaining why more safe assets implies greater shadow bank funding volume, I haven't seen anything explaining how this might lead to more lending to non-financials. Do you know of anywhere where this argument is set out?

Side question: We hear a lot about market demand for safe assets. From people who usually espouse the virtues of free markets (which I also espouse!).

Okay then--why does not the free market generate safe assets, if there is such a torrid demand for such?

It seems to me that a real estate loan in the under 30 percent loan-to-value range is a safe asset. Even in this last bust, prices fell about half, in most worst cases. This could be a loan on the first 30 percent of value on a small set of office buildings or apartment complexes, for example. Not a complicated underwriting.

So what some people are saying is that the private-sector does not have the ability, or gravitas, to develop safe assets.

Well, that's an odd one. Although with the collapse of AIG---that is, bond insurance was worthless without a government back-up---maybe I see the point, maybe the private-sector cannot generate safe assets.

If so, then the reflexive anti-government and anti-Fed crowd needs to re-evaluate their sentiments regarding government. Who else can provide safe assets?

Now back to the counterfactual point. Are QE critics really making the same mistake as George Bailey? To answer that question, let's think through the counterfactual of no QE2 and QE3. First, assume the Fed's share of marketable treasuries was constant over this period. Also, assume that the shocks from the Eurozone crisis, China slowdown, debt limit and fiscal cliff talks still buffeted the U.S. economy during this time. What would have happened to the U.S. economy? Could the U.S. economy have been as resilient to these shocks had the Fed not been supporting it? If not, then imagine the mess in the financial system and what that would have done to the demand for safe assets. Repo markets, for example, would probably be facing an even larger collateral shortage. A reasonable counterfactual, then, is that the safe asset problem would be greater were it not for the Fed's QE programs.

I'm sorry David, but I do not see the logic at all. How does the Fed buying up more safe assets alleviate the shortage of safe assets?

Note that asset prices have positively responded to QE2 and QE3. This has created a wealth effect that in turn has improved balance sheets, increased financial intermediation, and lowered risk premiums relative to where they would otherwise be. All the lamenting about the Fed creating news bubbles speaks to this point. So is the fact that the supply of safe assets has grown under QE programs (see chart in this post ) or that treasury yields have on net risen (see here ).

The point of my post is that had the Fed not been doing QE, these positive developments would not have occurred, risk premiums would be higher, and the safe asset problem more pronounced.

I encourage you to read this previous post where I spell out how the Fed is helping the safe asset program through expectation management. It is where I got this quote:

"The LSAPs, if done right, should raise expected economic growth going forward and cause asset prices to soar. This, in turn, would increase the current demand for and supply of financial intermediation. For example, AAA-rated corporations may issue more bonds to build up productive capacity in expectation of higher future sales growth. Financial firms, likewise, may start providing more loans as the improved economic outlook makes households and firms appear as better credit risks."

David, let me expound a little more. The safe asset shortage exist because of (1) reduction in the supply of safe assets (private label ones) and (2) and a sharp increase in safe asset demand because of flight to safety.

The immediate effect of LSAPs is to remove safe assets (treasuries). I This, however, is offset by (1) the LSAPs increasing the supply of private safe assets as outlined above and (2) reducing the elevated demand for safe assets. And, as I noted above, even if the new private safe assets are not used directly as collateral, they can still satiate safe asset demand elsewhere and free up treasuries for use as collateral.

Well, alright. I just did not see where the logic was living in the quote I made reference to. Yes, one believes that the Fed, via QE, raise future growth prospects, then fine. Anything that raises future growth prospects will also alleviate the safe asset shortage.